- Fixed Income Portfolio Manager
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I have deleted draft after draft of my thoughts on this subject, just trying to keep up with new developments. But for now, here are several ways I believe China can offset the tariff shock to its economy and respond to the trade war with the US.
Fiscal spending in focus
If the US tariff rate on Chinese exports remains above 100%, most of China’s exports to the US would be significantly reduced. Various estimates suggest an average hit to China’s real GDP of about 2%, which could rise to 3% – 4% if the global economy slides into a recession. To avoid a major economic contraction, China could implement a fiscal expansion of two to three trillion renminbi (approximately 2% of GDP) over the course of this year. Markets will be watching for such an announcement at the Politburo meeting later this month (with potential early measures announced sooner).
I would expect the government’s policy measures to focus on bolstering domestic demand via investment and consumption. For example:
- Continued expansion of existing stimulus initiatives, including infrastructure construction in renewable energy and power utilities, as well as subsidy programs for durable goods trade-in and equipment upgrades.
- Investment in human capital, a new term for the government that encompasses public services in education; public health and safety; cultural activities; and maternity, childhood, and elder care. These “soft infrastructure” areas have been largely neglected during China’s rapid modernization and are now expected to bolster service sector employment to absorb exporter job losses from the trade war.
- Services consumption stimulus, particularly in tourism, entertainment, and catering.
- Targeted cash relief for specific demographic groups, including low-income households, rural residents, multi-child families, and those with elder-care responsibilities. The goal here is to optimize spending versus saving, and the fiscal outlay will fall largely on local governments.
- Limited large-scale property-market stimulus, with a focus on stabilization and the continuation of inventory and land-repurchase programs, as well as urban village redevelopments.
With all that in mind, in the event of a global recession, Beijing would struggle to fully offset the economic drag of tariffs. The domestic appetite for another round of global-financial-crisis-level stimulus (which was approximately 10% of GDP) is smaller now, and the stimulus would take longer to take effect. If a recession starts, we might see a government balancing act between partial policy offsets and a reset of growth targets to around 2% – 3%, with a focus on maintaining basic economic functioning and ensuring social stability.
Potential trade-war retaliation tools
Beijing has several retaliatory methods at its disposal; some are more about grabbing headlines, while others can cause real pain for the US. Given its trade surplus, China has limited effective tools to push back against the US, and I believe Beijing hopes to leave the door open for a potential deal with the Trump administration. That said, I would not be surprised to see Beijing resort to any of the following tactics:
- Refusing to call the White House or respond to its overtures
- Stopping cooperation on fentanyl control and other geopolitical matters
- Restricting imports of US agricultural products and diversifying sources of agricultural imports
- Restricting exports of critical materials, including rare earth elements and key pharmaceutical ingredients
- Pressuring domestic exporters to pass on tariff costs to clients or halt delivery of critical products
- Seeking broader collaboration with other US trade partners on trade or dealing with the White House
- Imposing surcharges on the use of US software, intellectual property, licenses, and various services imports
The last point is tricky to enforce and more about grabbing headlines, but it does shift the focus from goods to services exports, in which the US has massive surplus that the White House omitted from its reciprocal tariff formula.
Conditions for negotiation
Beijing ideally wishes to return to the pre-tariff situation but understands that it is unrealistic. An acceptable baseline may be a return to the point before the “reciprocal” tariffs were put in place, e.g., with a 20% or lower across-the-board tariff on fentanyl, for example. The likelihood of the US prioritizing negotiation with China is low at this stage, but this could change in the event of a mutual pause of reciprocal tariffs. While a grand bargain is also unlikely for now, there are some olive branches that Beijing may be willing to extend to its counterparts in Washington, ranked from easiest to hardest to execute:
- Fentanyl control
- Buying more US Treasuries
- Direct investment in the US
- Purchase agreements
- Deals on TikTok and the Panama Canal
- Coordination on Ukraine and the Middle East
- A currency pact
- Economic/industrial policy rebalancing
Other ways China could retaliate
What else does China have in its retaliatory arsenal?
Weaponizing the yuan
While devaluing the yuan (CNY) is possible, the blowback would be significant. Historically during global crises, Beijing has opted for a stable exchange-rate policy rather than a “beggar thy neighbor” approach. A significant currency devaluation (10% – 20%) would not improve the economics for exporters and could trigger massive capital flight, confidence loss, a cycle of deflation, and accusations of currency manipulation — which would open the door to a wide range of additional sanctions, such as delisting, divestment, and asset freezes. That said, if the US-China relationship deteriorates further or if the US succeeds in pressuring the rest of the world to isolate China behind a “tariff wall,” weaponizing the CNY could become a viable option.
Weaponizing Treasury holdings
The recent tariff back-pedaling in response to the US bond market rout would suggest that China should keep hitting the US at this weak spot, but I believe Beijing is more likely to pile onto existing US Treasury market troubles rather than initiate an all-out bond war. Ultimately the US Federal Reserve (Fed) can absorb whatever Beijing would dump on the open market, making it an unwinnable battle for China. (There are also bigger questions on where and how China could redeploy the proceeds, particularly if it faced sanctions. Even if Beijing managed to repatriate the proceeds, it would face a major problem of how to anchor the domestic currency, which has long been backed by the safe-haven Treasury holdings on the government’s balance sheet. Sudden reanchoring would be hugely disruptive, creating a confidence crisis that destabilizes the macro environment.) Instead, Beijing could use its Treasury holdings as leverage to make a deal, with China committing to help fund new issuance, providing underpinnings for the US bond market.
Challenges with de-escalation
At this point, a quick retreat from the trade war will be difficult to do without inflicting a heavy toll on either (or both) economies. Further tariff hikes no longer make sense; the situation has become a test of economic resilience and pain tolerance. Any movement from here is up to two men with strong egos whose closest advisors have been unable to dissuade from the brinksmanship. Economic analysis can only help so far, and things will likely get worse before they get better.
One of the biggest problems, as I see it, is the lack of knowledge on both sides (including among investors) about the motivations of the other side. People in the US asking, “Why hasn’t Beijing caved and called the White House yet?” and people in China asking, “Why hasn’t the rest of the world dumped US dollars and Treasuries already?” don’t fully appreciate their adversary. This mismatch is a recipe for policy mistakes on both sides. The rapid-fire tit-for-tat response from China to raise its tariffs on US imports is one example. Beijing may have overplayed its hand and is now in an awkward position of being singled out by Washington. That said, this has probably just accelerated the journey to a showdown and, potentially, economic decoupling.
The structure of the US and Chinese economies are opposite versions of extreme imbalances, which used to cancel out, thanks to economic integration. No longer. After 2018, China had to find alternative sources of demand and the US alternative sources of supplies. Further testing of these efforts from here will expose vulnerabilities in the global supply chain.
Additional considerations
Monitoring micro signals
It is vital to monitor signals such as supply chain breakdowns, shipment delays, production disruptions, capital flow interruptions, volatility swings, and liquidity/solvency crises. These micro stresses can accrue to cause a macro “snap” moment (at which point policy tools may be ineffective), making it crucial to address them proactively.
Risks around Taiwan
The risk of the trade war spilling over into the strategic and military realm is rising, although it remains a tail risk. If the global tariff continues to erode US credibility and leadership, or if Washington faces deep economic trouble, the risk could increase. It is important to monitor these risks as they materialize.
Closing thought
The gloves are off in the US and China trade war, presenting significant challenges and uncertainties for investors to navigate. While Beijing has many tools at its disposal to offset the tariff shock, retaliate, and offer some concessions, the path to de-escalation remains complex and fraught with risks for the global economy. It is essential to monitor the evolving situation and be prepared for potential policy adjustments.
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